Lecture 4 - Cost and Time Planning

Question 1

What are the two ways in which costing approaches can be derived?

Answer 1

1. Top-down costing.

2. Ground-up costing.

Question 2

Describe top-down costing:

Answer 2

• Budget set by people who negotiate with the clients.
• Budgets may be too optimistic; no buy-in from project team.
• Project manager allocates budgets to sub-projects.
• Costs fixed externally to project.

Question 3

Describe ground-up costing:

Answer 3

• Budget set by those who actually do the work.
• Can lead to inflated budgets and renegotiation with senior management.
• Risk of missing work packages.
• Project manager collates estimates.
• Costs set by the project.

Question 4

Give examples of ‘direct costs:

Answer 4

• Salaries and wages
• Materials, machinery (usage costs)
• Third party services (consultants)
• Other expenses: travel and accommodation.

Question 5

Give examples of ‘indirect costs:

Answer 5

• Overhead costs for general management (e.g. office space, training, typically % of direct costs).

Question 6

Give examples of ‘below the line costs:

Answer 6

• Contingency for unexpected costs (% of direct & indirect costs).
• Profit mark-up (if sold to external clients).

Question 7

What technique is used to estimate the cost of projects?

Answer 7

Parametric Estimation.

Question 8

Describe ‘parametric estimation’:

Answer 8

For “as … but …” and “painting by numbers” projects:
- Determine major cost factors in previous projects
- Use regression model to estimate costs of current project based
on previous projects (e.g. via multi-variate regression analysis)

For “first timer” and “as … but …” projects:

• Forecast cost factors, units and per-unit costs in each WP
• Aggregate costs over all work packages in the WBS.

Question 9

Define ‘payback period’:

Answer 9

The amount of time that is required for the project to “pay
itself off”, i.e., until revenues break even with costs.

Payback criterion: prefer projects with shorter payback period

Question 10

What are the advantages of the payback analysis?

Answer 10

• Criterion is easy to understand and in widespread use.

- Future payments are subject to higher uncertainty.

Question 11

What are the disadvantages of the payback analysis?

Answer 11

1. Costs/benefits beyond payback period are ignored.
   - Long-term benefits for the company
   - Decommissioning costs at end of lifetime
2. Time value of money (“£1 today is worth more than £1
   tomorrow”) is ignored.
   - See discounted cash flows and internal rate of return
3. Only useful for comparing different projects.
   - By itself, it does not say whether project is valuable or not

Question 12

Define ‘cash flow’:

Answer 12

Any money movement into or out of the company:

• Revenues generated by the project
• Costs incurred by the project

Question 13

Define ‘present value of a project’:

Answer 13

Sum of present values of all project-related
cash flows (“cash equivalent” of project).

Question 14

What is the explicit expression for the PV of a project?

Answer 14

PV = CF0 + CF1 x (1 + i)^-1 + …

Question 15

What are the advantages of the discounted cash flow method?

Answer 15

PV criterion:

• Project is only viable if its present value is positive
• Choose project(s) with highest present value(s)

Advantages:
- Allows evaluation of single project and comparison of projects

Question 16

What are the disadvantages of the discounted cash flow method?

Answer 16

Unclear which interest rate to use.

• Interest rate offered by bank?
• Weighted average cost of capital?

Interest rate may change over time; difficult to forecast
- Does not reveal anything about rate of return.

Question 17

Define the ‘internal rate of return’:

Answer 17

Internal rate of return: interest rate that makes present value = 0

Question 18

What are the advantages of the internal rate of return?

Answer 18

IRR criterion:

• Project is only viable if IRR exceeds cost of capital
• Choose project(s) with highest IRR(s)

Advantages:

• Allows evaluation of single project and comparison of projects
• Accounts for the time value of money, as well as rate of return

Question 19

What are the disadvantages of the internal rate of return?

Answer 19

Unclear how to choose cost of capital.

IRR may not be unique for given cash flow stream.
- Guaranteed to be unique if first cash flow is negative, and remaining cash flows are all positive.

Implicit assumption that money can be reinvested at IRR.

Question 20

What are the 4 challenges of financial analysis?

Answer 20

Financial appraisal is only one side of the coin.

• Strategic benefits (e.g. organizational change, future products)
• Non-profit organizations (e.g. disaster relief projects)
• Ethical or environmental concerns (e.g. labour reduction)

Cash flows may be difficult to estimate.
- Especially in projects with high uncertainty

“Optimism bias” in business cases.
- “Understated costs + overstates benefits = project approval”

Positive/negative interactions with other projects.

• Synergies between different projects.
• Cannibalising products in a narrow market.